What Set the Stage for the Financial Crisis
US markets rose higher in the second quarter. The rally mostly benefitted large companies, with the S&P 500 moving up 5.07% and all ten sectors contained within it advancing. Small companies regained ground after a difficult start to 2014, finishing up 2.4% for the quarter.
Second quarter economic output figures are expected to be strong based on an improving labor market and positive consumer sentiment. However, contrary to the general market perception that domestic economic growth would cause interest rates to continue rising in 2014, the ten-year U.S. Treasury yield actually moved lower. This was driven by a high demand for US bonds as global investors found US markets relatively more attractive than other areas of the world. Concerns included slower economic growth in China, an escalating situation with militants in Iraq, and continued unease over stagnant European economic growth.
Moving to foreign markets, with fears of falling prices still present in Europe, the European Central Bank (ECB) unveiled several bold new measures aimed at stimulating economic growth across the region. Among these new measures was an unprecedented move to reduce the interest rate on deposits from 0% to -0.1%, making it the first central bank to impose negative rates on its depositors. Mario Draghi, the ECB president, also alluded to further action if necessary, which many assume to mean large scale asset purchases, similar to the US. The market reaction was positive, sending European indexes higher.
Emerging market stocks built upon the rally that started in the first quarter, helped along by a positive reaction to the general election results for Prime Minister in India. After raising rates in order to stem capital flight and the falling value of their currencies, central banks of emerging economies may now be in a position to reduce interest rates, which could provide a tailwind for companies.
Q2 2014: 5 Years Later, What’s Changed?
We recently attended the 67th Chartered Financial Analysts Institute annual conference, a global investment conference featuring the latest thinking from top experts in the investment management field. While many of the topics were quite technical, overarching themes revolved around the questions:
- What, if anything, has fundamentally changed since the 2008/2009 financial collapse?
- How should one think about and prepare for future events?
As we listened to various discussions on these questions, we came away with fresh confidence in our approach to helping you with your investments, and we want to pass along the insights that we gained.
WHAT SET THE STAGE FOR THE FINANCIAL CRISIS
We don’t want to oversimplify what caused the financial collapse, but it helps to focus on one singular concept: Debt. Many used borrowed money to consume too much and simply didn’t save for a rainy day. The first chart at right shows the Household Debt Service Ratio, which measures the ratio of total household debt payments to total disposable income. Note the steady rise in debt leading up to 2008. Concurrently, there was a steady decline in household savings rates. Consumers saved less, spent more, and took on debt to fuel their growing lifestyle. By 2008, U.S. households owed about 10 times as much as they had in the 1980’s, which is a clear indication that using debt to buy a better car, bigger house, and a “better life” had become a culturally acceptable norm.
A similar story played out across corporate America. Whether it was real estate developers taking on massive debt to build properties in the boom time or investment bankers repackaging mortgage securities three times over, debt was in high demand. Investors got caught up in complex debt-based investment vehicles, chasing higher yields without truly understanding the risks. While the catalyst for the financial collapse may have been the poor practices of individual companies like Bear Stearns, Lehman Brothers, AIG, etc., the underlying issue of massive debt was widespread. Although not blatantly obvious at the time, the financial collapse was an accident waiting to happen.
HAS ANYTHING CHANGED?
The short answer is “yes.” Excessive use of leverage is nowhere near pre-2008 levels amongst consumers and corporations. Corporate profits remain healthy and cash levels are high. Less borrowing is good news in terms of reducing risks to the financial system. However investors and investment experts alike find themselves wondering if the current market environment still bears similarities to markets before the financial crisis.
Although consumer and corporate borrowing has decreased, government borrowing has increased. The Federal Net Debt, which compares total national debt to domestic economic output, shows an alarming increase since the financial crisis. While there is a strong argument that an increase in government spending was necessary to revive our economy back to life, the long-term impacts remain to be seen. The bottom line is that although the players may have changed, the concept remains the same: America still uses a lot of debt.
The U.S. is considered a safe haven for global investors. Many don’t see this changing anytime soon, especially since similar financial stresses exist all over the developed world. Regardless, as the financial crisis illustrated, debt by its nature represents risk. As in any market environment, one needs to be prepared for uncertainty and difficult times.
HOW SHOULD ONE PREPARE FOR FUTURE EVENTS?
Czech economist and conference speaker Tomáš Sedláček authored the book Economics of Good and Evil, in which he observes economics from a unique perspective. He studies ancient historical accounts in order to identify basic economic principles, simple principles that were established before sophisticated economic institutions like the Fed or the European Central Bank, even existed.
Sedláček identified that the first recorded economic cycle is found in ancient Egypt as articulated in the Judeo-Christian Bible and in Egyptian historical texts. In this account, Egypt’s Pharaoh has a disturbing dream of seven skinny cows eating seven fat cows, which is interpreted as a forecast for seven years of abundance followed by seven years of poverty and famine. “The abundance in the land will not be remembered, because the famine that follows it will be so severe.” (Genesis 41:31) This sounds a bit like events before and after our country’s own Great Recession, doesn’t it? There was a time of extreme abundance followed by a much more challenging time that made it difficult to remember that the good times ever even existed.
So how did the leader of ancient Egypt, the world’s greatest economy at that time in history, plan for the dramatic economic cycle that he was anticipating? His advisor Joseph (Imhotep in Egyptian accounts) recommended that Pharaoh save 20% of all the crops that were harvested during the good years and to store this in secure locations in order to provide a protected reserve for the bad years. In other words, the plan was to consume less than was grown in the good times (rather than behaving as if the good times would continue indefinitely) and to establish safe reserves to prepare for the drier times that would inevitably come. It was a simple plan that made good sense.
In modern economies the Fed and other central banks use debt as a tool to help smooth out economic cycles. Sedláček contends that while debt serves a very useful purpose, its ubiquitous use complicates our perspective and makes it possible to lose sight of the most basic underlying principles: 1) We should never spend all that we bring in; and 2) It is wise to hold something in reserve for tough times. If individuals, corporations, and governments adhered to these principals, markets would still ebb and flow, but the impact of crises would be less severe.
The complex interaction of today’s economies and the nature of the political environment make it highly unlikely that global leaders will adhere to the principles of Sedláček’s book (if they read it at all). Regardless, these same principles can be applied to individuals, and we contend that you, our clients, already apply these principles in your well-constructed financial plans and investment portfolios.
SPENDING LESS THAN YOU EARN
The first step we took in helping you design your financial plan was to understand your goals and to help you save enough to fulfill them, which required spending less than you earned. Similarly, in retirement, we never recommend that clients set their retirement spending levels anywhere close to the annual rate of return that we actually expect the investment portfolio to earn on average. While an investment portfolio may earn 6% – 8% over long periods of time, most of our clients calibrate their spending at just 3% – 4% of their portfolio value.
Many learned in the financial crisis that they had taken on far more risk than they realized and, as a result, they no longer had the resources to sustain their financial commitments. Some investments lost all of their value, never to be recovered. Other investments were sold at inopportune times in order to meet cash needs or debt obligations.
As you know, we place all investment asset categories on a continuum of time and risk that is carefully matched to your needs for cash flow. This helps to ensure that you have plenty of cushion in cash and high-quality bond investments to make it through tough times in the economy and markets. We always strive to never invest in aggressive asset classes if we expect that you will need it within 10 years.
We don’t know what the markets will do over the short-term, whether they will continue to reach new highs or will experience a steep correction. If there is one thing we know for certain though, it is that you should expect another economic period of economic weakness at some point. At that time, hopefully you can take solace knowing that we have prepared your long-term forecast with conservative assumptions for your spending relative to expected investment returns and that we keep a careful eye toward retaining reserves in safer asset classes in order to make it through difficult periods in the markets. It is also good to recount the basic principles that sustained you in the last correction, which include:
- Controlling spending
- Using debt cautiously
- Carefully selecting your asset allocation mix between stocks and bonds
- Maintaining at least 10 years of cash flow needs in safer assets
- Utilizing high-quality and straightforward investment products
- Resisting the emotional urge to chase climbing markets or sell-off investments in weak markets
Adhering to these foundational principles can be expected to provide benefits whether or not financial markets provide positive or negative returns this year or next.